Covered-Call ETFs: Approach with Caution

Sure, they can produce income that beats bonds and dividend stocks, but you can't add yield without adding risk, writes Rob Carrick, reporter and columnist for The Globe and Mail.

You can make a lot of money in the investment business by trying to help people defy the gravitational pull of low interest rates.

The latest product to attempt this is a type of exchange traded fund that uses a strategy called covered-call writing. Covered-call ETFs are offering yields right now in the 10% to 15% range, which compares with a peak 3.5% on five-year guaranteed investment certificates and not much more than 2% on five-year Government of Canada bonds.

One of the most frustrating rules in investing is that you can't add yield without adding risk. Covered-call ETFs are no exception, although you could easily be lulled into thinking otherwise if you don't dig into the details.

Covered-call writing, sometimes called a buy-write strategy, is a comparatively complex investing technique where you:

Buy stocks;

Write, or sell, call options that allow other investors to buy your shares at a predetermined price.

You're paid a premium for the options you write, and therein lies the benefit of covered-call writing.

The covered call strategy can produce income that beats not only bonds, but also dividend stocks. That's the case with the BMO Covered Call Canadian Banks ETF, which has generated a yield of about 10% by writing calls on Big Six bank stocks that are themselves yielding in the 3% to 4.5% range.

In a down market, income from the option premiums could offset your losses to a limited extent. In a rising market, well, here we arrive at the vulnerable point with covered call writing. What you typically hear from ETF firms is that covered call writing gives you high income at the expense of limitations on appreciation in the value of a fund.

What you don't see mentioned is how this might affect you in a period like 2008 to 2009, when the markets fell hard and then began a fast and furious rebound. You could end up with an ETF that falls somewhat less than the stocks it holds, but also lags significantly on the upside.

This unusual pattern of returns helps explain why Eric Kirzner, a finance professor at University of Toronto's Rotman School, is cautious in describing the appropriate use of covered call ETFs.

"I can see a portion of a portfolio allocated to them, with the caveat that the investor understands how options work," he said.

NEXT: A Growing Market

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A Growing Market
There are now about nine covered-call ETFs listed on the Toronto Stock Exchange: the Bank of Montreal (BMO) covered-call banking fund, plus four products from Horizons Exchange Traded Funds Inc. and four from a new player, XTF Capital, which is owned by First Asset Capital Corp.

BMO's fund has grown to almost $300 million since its launch in late January, which is impressive. Horizons says its AlphaPro Enhanced Income Equity ETF has been taking in almost $2 million a day for the past couple of weeks, and since its launch in March has attracted almost $23 million.

Eden Rahim, who manages the Horizons covered-call ETFs, said this investing strategy is used by pension funds, insurance companies, and other institutional investors to both reduce volatility and enhance returns.

"All we're doing is taking that defensive strategy and bringing it to retail investors in a structured ETF," he said.

Rahim concedes that covered-call writing will underperform in a strong bull market, but he argues that it will outperform in falling, flat, and gradually rising markets. As evidence, he cites comparative recent returns for the S&P 500 index and the CBOE BXM index, which was created as benchmark for a covered-call strategy applied to the S&P 500.

Here's a summary of his findings on how covered-call writing performs in different market conditions:

The modest bull market: From March 1991 to September 1994, the S&P 500 rose 39% and the CBOE BXM rose 57%.

The bear market: The S&P 500 was down 51% from June 2007 through December 2008, while the CBOE BXM fell 36%.

The range-bound market: The S&P rose 1% from February 2004 to October 2004; during the same period, the CBOE BXM popped 3%.

The strong bull market: S&P 500 jumped 93% from March 2009 to March 2011, while the CBOE BXM gained 54%.

"If you're a super bull and think the market is going to advance vertically, this product is not for you," Rahim said of covered-call ETFs. "If you think the market is going to do something other than advance vertically, as it has in the past couple of years, then this is something to consider."

The Caveats
It's worth noting that covered-call ETFs have been introduced by the smallest players in the Canadian market. Notably absent in this category are second-ranked Claymore Investments and the iShares group, by far the market leader.

"At this point, we've decided that there are better ways to meet the demand for income," said Mary Anne Wiley, managing director for iShares parent BlackRock Asset Management Canada. An example is the new iShares S&P/TSX Equity Income Index Fund (XEI), which takes the comparatively transparent approach of holding up to 75 dividend stocks that produce dividend income yielding about 5.2% after fees.

Covered-call ETFs require more active management than your basic index-tracking product, so the fees are higher. The Horizons covered-call ETFs have a management fee of 0.65% and trading costs could take the total cost of owning them close to 1%.

In non-registered accounts, covered-call ETFs benefit from more favorable tax treatment than bonds or GICs. Horizons reports that there are two components to the distributions from its covered-call ETFs: Dividend income and capital gains from the call premiums.

Covered calls, even while they're mainly about income, should be included with the stocks in a portfolio and not the bonds.

Kirzner said that the weighting for covered calls could go as high as 20 to 30% of a portfolio. But he's quick to qualify that this applies strictly to investors who rank on the high side of his investing-knowledge scale, which starts at novice, then rises to fair, good, and sophisticated.

"I want to see investors at least in the upper end of the good or the lower end of the sophisticated range before they should look at a product of this sort."

NEXT: New Choices for Income Seekers

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New Choices for Income Seekers
Introducing the covered-call exchange traded fund, a new offering for knowledgeable, risk-tolerant investors who are seeking higher levels of income than they can get from dividend stocks or bonds.

Nine covered-call ETFs have been listed on the Toronto Stock Exchange this year:

Fund

Ticker

Fee (%)

Yield (%)

BMO Covered Call Canadian Banks ETF

ZWB

0.65

10

Horizons AlphaPro Enhanced Income Equity ETF

HEX

0.65

15.5

Horizons AlphaPro Enhanced Income Energy ETF

HEE

0.65

15.1

Horizons AlphaPro Enhanced Income Gold Producers ETF

HEP

0.65

15.4

Horizons AlphaPro Enhanced Income Financials ETF

HEF

0.65

14.8

Can-60 XTF

LXF

0.65

n/a

Can-Energy XTF

OXF

0.65

n/a

Can-Financials XTF

FXF

0.65

n/a

Can-Materials XTF

MXF

0.65

n/a

Notes:

Fees shown here include only the management fees; extra costs, notably trading fees, would increase the total cost of owning these ETFs.

Yields are based on monthly distributions to date and may not accurately reflect what would be paid over the course of a full year.

The four XTF funds were listed just this week, bringing the total number of ETFs on the TSX to above 200.